Nov 09, 2017

The 4 Percent Rule is Dead

By Byron Ellis

If you are nearing or in retirement you most likely have heard of 'The 4% Rule.' This guide stemmed from a study done in 1994 that looked at historical returns of the market to determine the “safe” withdrawal percentage that one could pull out of a portfolio over a 30 year retirement span. The study included an inflation factor which means that the annual income from the portfolio could go up over time. That original study concluded that at no time in the past did a 4% withdrawal exhaust a portfolio over any 33 year time frame. The bottom line is that most professionals and retirees have used this as a rough guide when pulling money from a portfolio.

Should we still rely on 'The 4% Rule?' I say no. I think the safe percentage has dropped. You see, before the 4% rule became the norm, the thought was that a 5% withdrawal rate would be fine. It was not until the early 90s that the recommended distribution amount was reduced to 4%. It may be the time to follow a new and lower 3% rule. According to Morningstar, a portfolio made up of 50% stocks and 50% bonds with a withdrawal rate of 4% has a 40% chance of running out over a 30 year span. This can be a little disheartening when you built your entire retirement income projection using a base of 4% withdrawals! What do you do?

Face the fact that 4% may be too high. Don’t ignore what is going on right now. Return projections may be lower than they were 20 years ago. Markets are more global. Returns over the last 10 years and the foreseeable future may stay in the single digits. Plan for it.

Use 3% instead of 4%. If you have enough money, using 3% may increase the likelihood that you do not run out of money. If you need to pull $40,000 per year from your portfolio at retirement, the amount of wealth needed would increase from $1,000,000 to $1,333,333. If you have not retired yet, take a look at your target and adjust now if needed.

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Front load retirement expenses...and then pull back. In the first few years of retirement, it is likely that your will spend more per year than you did before retiring. Most people are shocked when they learn this, but think about it, more time and more freedom leads to stuff that costs money. Retiree expenses usually drop off somewhere around year 5-10. So what does this mean? It means you may be able to have a larger distribution rate in the beginning years and then pull things back. The assumptions will need to be tested using some good financial planning software but it could be worth it to give you the income needed to enjoy life when you want to continue to be more active.

Consider holding more stocks. This is not for the faint of heart. Stocks as a broad investment asset class have more growth potential than bonds over long time periods, albeit with higher risk. Consider beefing up the stock side of your portfolio if you are someone that can handle the fluctuations in the market. No one said that just because you were retired you are not allowed to invest in hold a growth oriented portfolio.

Live on less in down years. Back in 2008-2009, the markets, both stocks and bonds, were reeling. I am sure you remember. We found that most individuals felt out of control. It was a sinking feeling that there was nothing within your power to save your financial future. Everything was going down and there was a deep sense of hopelessness. During that time period, we assembled a team to see if we could somehow get the control back into our retirees hands and get rid of the helpless feeling. We ended up testing an assumption that worked in almost all cases. With a planning software, we ran a projection near the bottom of the market to see how long a hypothetical portfolio would last using their current expense level. We then dropped expenses by a small 10%, which reduced the portfolio distributions, and ran it again. What happened was pretty shocking. In all cases, the lifespan of the hypothetical portfolio extended and the control went back to the hypothetical retiree. What we determined was that if the markets don’t cooperate, we still have it in our power to reduce expenses...even if it is a temporary change. So, by dropping the distributions, this hypothetical investor could regain physiological control, and weather the downturn. You may do the same in the next down market by cutting your expenses.

So if 3% is the new 4%, you may want to take a look at what your distribution rate is. If you are in the beginning stages of retirement, shoot for something closer to 3%. As you get older, the number could go up since you may not have a full 30 years ahead of you. Feel free to ask your adviser to help make sure you are staying in a healthy income zone.

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